India’s real economic growth looks healthy but fiscal space will shrink unless its nominal pace picks up

The concern comes from the fact that the growth in nominal gross domestic product (GDP) is likely to be a tepid 8%, the lowest rate since the financial year ended 31 March 2003.

The slim difference of 0.6 percentage points between these two measures of economic momentum is explained by a collapse in the GDP deflator, a measure of inflation used by government statisticians to squeeze out the effect of price increases to arrive at the growth in real output.

This very low nominal GDP growth rate has profound implications for Indian fiscal policy, even as finance minister Nirmala Sitharaman prepares to present the new Union budget on 1 February.

The finance minister had announced last year that India would have a new fiscal policy framework under which the main aim would be to bring down the ratio of public debt to GDP over the medium term. The annual budgetary balance would be the instrument used to achieve that aim.

This is broadly similar to the approach that the Reserve Bank of India takes. It seeks to keep inflation close to target through changes in the interest rate. For those with a taste for jargon, the annual fiscal deficit is now the intermediate policy target, while the public debt to GDP ratio is the final target.

Nominal GDP growth has a starring role in the quest to stabilize public debt in any economy. Public-debt dynamics can be understood through a simple equation.

The change in the debt-to-GDP ratio depends on two variables. First, the primary deficit, which is government spending minus revenues, after you exclude interest payments. Second, what economists call the ‘r minus g’ differential (r-g), which is the gap between the nominal rate of interest the government pays on its debt and the nominal growth rate of the underlying economy.

The upshot: The burden of public debt can be managed if either the government brings down its primary deficit or the economy grows faster than the cost of borrowing, or some combination of the two factors.

The primary deficit is controlled directly by the government through budget choices on how much revenue to mop up, how much money to spend and how much to borrow from banks to fund the fiscal deficit.

On the other hand, the (r-g) differential captures the structural forces largely beyond immediate policy control. When a government reduces its primary deficit, it directly cuts how much new debt it needs to pile on each year.

However, even if you balance the primary budget completely, your debt ratio can still rise if interest rates exceed growth rates, creating a snowball effect. Conversely, when nominal growth outpaces interest costs—as it often does in India—the denominator effect works in our favour, allowing the economy to grow its way out of debt even with moderate deficits.

The relative importance of these two factors has varied dramatically across time and geography, offering lessons for India’s own fiscal trajectory. European countries in the 1990s faced the painful reality of a positive (r-g), forcing them to run large primary surpluses just to meet Maastricht criteria, a politically bruising exercise that still shapes their fiscal conservatism today.

Japan tells a different story. Decades of ultra-low interest rates have kept (r-g) deeply negative, allowing the country to sustain debt levels above 250% of GDP without triggering a crisis, though whether this is sustainable remains hotly debated.

India has usually been in a sweet spot of combining strong nominal growth with relatively manageable borrowing costs. This has provided the breathing space to successive governments which allowed them to avoid severe austerity that would have hurt the broader economic momentum.

The recent decline in nominal GDP growth, or the ‘g’ in the (r-g) metric, could now create complications. It adds to pressure on the government to run a tighter fiscal policy.

The numbers tell the story. The difference between the rate at which the government borrows in a particular year and the growth in nominal GDP is now at one of the most unfavourable levels in the past 25 years.

The interest costs considered here are the weighted average cost of government borrowing in a particular year. It would complicate the task of fiscal policymakers unless either nominal GDP growth accelerates in the coming years or interest rates decline sharply. And it is important to remember that what applies to the finances of the Union government also applies to states, many of which seem headed towards a fiscal cliff.

India has managed to bring down its annual fiscal deficit after the pandemic shock, a big boost for the policy credibility of the government. However, it may need some fiscal firepower to support domestic economic activity in the coming years in case the international situation turns even more ugly. A sharp decline in nominal GDP growth will restrict the ability of the government to stimulate the economy while maintaining public-debt-to-GDP on a downward path.

The author is executive director at Artha India Research Advisors.